Cost of Goods Sold (COGS) refers to expenses related directly to producing or purchasing inventory items for sale or resale. Inventory is a line item on the balance sheet and is considered an asset that the company holds. Inventory is one of the most critical assets for companies in the distribution industry. When inventory sells, the revenue appears in the income statement. The cost of procuring that item is known as COGS. Manufacturers also use COGS for the purchase of raw materials.
Periodic inventory
Under the periodic system, the amount in the inventory account doesn’t update when a company is purchasing inventory; it updates after a specified amount of time, usually annually. The inventory amount is only updated after a fiscal year finishes and the new year starts; this means that the inventory account won’t show you the cost of the stock for last year. All the purchases related to merchandise are entered and recorded in either one or more than one purchase account. When the year is about to end, the purchase accounts are closed by the company. By following the periodic system, there is no cost of goods sold when recording the sale of merchandise.
Assumptions for cost flow
IRS accepts three methods to move the cost to the income statement from the balance sheet. The three methods used are FIFO, LIFO, and Average Cost. They display what their names suggest and direct the order in which items flow from the inventory and money is moved on the balance sheet. FIFO means first in, first out, meaning that goods should come out of stock in the order received and their costs shown at their original purchase price. LIFO means last in, first out, removing the most recently received item first and recording inventory at its original purchase price. It doesn’t matter if the cost of goods sold has increased for the new batch; you must use the cost at their original price.
Perpetual form of inventory system
While following a perpetual system, the stock account is being updated at regular intervals by the company. Inventory adjusts when the actual cost of products purchased from the suppliers occurs; on the other side, the accounts adjust immediately as the items sell to customers. There is no chance for purchase accounts in this perpetual system of inventory. The actual price of sold products has a history, and that account adjusts at the time each sale occurs, which is the same for the cost related to the merchandise. Sales and accounts receivable both change to the record as one entry. On the other hand, the different products added to the inventory list decrease, and they start to make maximum the price of products sold to the customers.
FIFO (first-in, first-out), LIFO (last-in, first-out), and Average cash flow assumptions are merged with any inventory systems, either perpetual inventory systems or periodic inventory systems, to determine the actual cost of the stock at hand. It depends upon you that how you can choose any one of them according to convenience and ease.
Indication of a perpetual system
The perpetual system clearly shows and ensures that a company’s inventory account will always show accurate figures as accounts update in real-time at regular time intervals. In other words, you can say that the balance in the Inventory account will start to increase by the amount of the goods purchased. This amount decreases by the cost of the goods when a sale occurs. So, it illustrates that the balance in the Inventory account should tell you more about the cost of the inventory items that are on your hand right now. Also, the companies should count the actual number and cost of their goods that they are having at the current time (take a physical inventory) at least once a year. They should adjust the perpetual records if necessary for the company.
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